Couch Potato Basics, Part 5: Tax Efficiency

This post is the fifth in a five-part series outlining the primary benefits of the Couch Potato strategy.

All investors have to deal with the erosion of their returns by fees and taxes. The first post in this series explained how using ETFs and index funds can cut your costs by 90% or more. Now let’s look at how index investing can also cut your tax bill.

Fair warning: this subject is rather technical and it may leave beginners baffled. The good news is that if all your investments are in registered accounts—RRSPs, RRIFs, RESPs or Tax-Free Savings Accounts—you don’t need to worry about it. But if you’re investing in a taxable account with actively managed mutual funds, you may want to settle in. It just might save you some money.

Most mutual funds are structured as open-end trusts, which enables them to avoid paying taxes. Instead, funds pass along any interest, dividends and capital gains to their unitholders. (Mutual funds incur a capital gain any time they sell stocks, bonds or other securities at a profit.) Usually all of these distributions are reinvested rather than paid in cash, but unitholders are still responsible for paying tax on them: that’s why you get that T3 slip in the mail every year.

Most investors expect to pay capital gains taxes if they sell their own mutual fund units at a profit. But the point here is that unitholders are hit with taxes even if they hold onto the fund.

In fact, they may even be on the hook for the decisions of other investors. Here’s why: when unitholders panic during a market downturn, the fund may be forced to sell securities in order to pay all those redemptions. If those sales incur capital gains, the remaining unitholders wind up footing the bill for those who bailed. It’s bad enough paying taxes on your profits. But imagine the shock of watching the value of your funds plummet during a crash, and then taking a second hit when you’re forced to pay capital gains taxes despite huge losses. (You can read a CNN Money account of how this happened to investors in 2008. It’s a US article, but the relevant tax laws in Canada are similar.)

Investors who unwittingly buy a mutual fund late in the year may also get a nasty surprise from the taxman. If the fund pays a capital gains distribution at year end, a new investor must pay tax on it even if the actual gain was incurred long before she bought into the fund. How fair is that? (For more, see this post at Where Does All My Money Go?)

Index fund investors must pay capital gains taxes, too, but because these funds passively track an index, they trade far less than actively managed mutual funds, and are therefore far less likely to realize gains.

More important for Couch Potato investors, ETFs are cleverly designed so that some are able to virtually eliminate taxable gains. The structure is complicated, but the basic idea is that ETFs do not have to keep cash on hand to pay investors who redeem their shares. The underlying stocks or bonds in an ETF are held by a third party called a designated broker, and the creation and redemption of units are made through in-kind swaps between this broker and the ETF sponsor. Because no cash exchanges hands, no taxable event is generated, and no capital gain is passed on to the investor. The system is not perfect, but many iShares and Claymore ETFs have never passed along a cent in capital gains to their unitholders. (If you want to better understand this arcane but perfectly legal structure, this article may help.)

If all of this makes your head spin, don’t sweat it. Just understand the key point: most ETF investors will never pay capital gains taxes unless they decide to sell their own shares at a profit. The tax efficiency of ETFs is one more way of making sure that more of your investment returns stay where they belong: in your pocket.

14 Comments

I am new to investing so my question may sound simple. If my investments are in a RRSP (down about 40%)then I don’t need to worry about high MERs and therefore don’t need to move my money into index mutual funds like TD e-series funds. Is this correct? I currently also have a TD TFSA where I am investing in the e-series fund so could transfer money over if it would be to my benefit. Any comments on this would be appreciated. I am enjoying reading about the Couch Potato Portfolio so keep up the great work.

Thanks for the question. Having your investments in an RRSP saves you from paying taxes, but not MERs. Moving your RRSP assets to TD e-Series funds will certainly reduce your costs.

You cannot transfer money from your RRSP to your TFSA without paying income tax on it. You can do it the other way around, however: you’ll just lose the TFSA contribution room until next year. If you’re confused, you may want to work with a TD advisor to make sure you set up your accounts properly.

JMan
June 3, 2011 at 4:33 pm

I read that some iShares mutual funds such as XIC and XIU will not only pay distributions in eligible dividends but also foreign income and RoC because of their income trust components.

In that sense, if held in an unregistered account, would it be better to get the TD Canadian Index – e that only pays eligible canadian dividends even if it has slightly higher MER and that capital gains may occur during the year?

I’m talking about buying a bunch (say 20k worth) and holding so trading costs have no effect here.

Thank you for your reply. I read about this also but decided against it because it apparently lack the in-kind creation/redemption mechanism of other ETFs (such as XIU/XIC) . So while you would have no taxable events during periods of “normal” economic activity, if the market crashes the fund might have to tax investors for redeeming large amounts of units. So your assets are melting away and you get extra taxes : not a fun scenario.

@JMan: I don’t think the scenario you describe can actually happen. Remember, HXT does not actually own the stocks: the counterparty does. HXT keeps all of its inflows in a cash account and can therefore use this cash to handle redemptions. You might want to give Horizons a call to ask about this. Anyway, I’m not trying to promote any specific ETF one way or the other. I just want to make sure that your decision is based on real risks. Cheers.

Edward
September 30, 2014 at 4:11 pm

Sorry for the reply on an old post, Dan. (Though it is loosely related to your recent series on tax efficiency.) I’m posting here in the basics, because it’s a totally newbie question. I’ve never had to sell anything in my taxable (non-registered TD mutual fund) account yet and have always re-balanced with new money. My question is: When the day comes in which I have to incur a capital gain on something by selling, will this information show up in a T3-type of slip from my bank with numbered boxes to plug into my tax return? Or is it a calculation I’m going to have to make solely on my own?

@Edward: If you sell something in a non-registered account your brokerage should send you a gain/loss statement at the end of the year with the details. Usually these are quite accurate (especially if it’s a mutual fund) but you would be responsible for ensuring that it is and then for reporting the gain or loss on your tax return.

Edward
October 1, 2014 at 11:59 am

Amazing–thanks, Dan!! (And for all your other tips/advice over the years.) I’lll have no problem verifying its accuracy. I was just a bit worried about the possibility of having to do it entirely on my own. It’d be new territory.

SBURK
June 2, 2015 at 3:38 pm

Hello,
I just started using the vanguard model portfolio for investing with my professional corporation. The funds are not in an RRSP or TFSA. If I rebalance by injecting new money every year ( I only plan on selling them in 30 years at retirement), do I need to pay any capital gains taxes before retiring? And are the profits/capital gains obtained that year automatically re-invested? Or do i need to reinvest myself through my National Bank discount brokerage?

Thank you so much, your website is amazing and it feels great to take control of my finances.

@SBURK: With minor exceptions, any capital gains on your ETF investments will just show up as increases in the value of your holdings: you don’t need to reinvest anything. You would only need to pay tax on these gains when you sell shares that have appreciated in value.

However, every year you will need to pay taxes on any dividends and interest paid by the ETFs. The amounts will be reported on the T-slips you receive in the mail in February or March.

Chad
August 21, 2015 at 3:15 am

Hello and thank you again for all your information. I am new this year as a DIY investor following your CCP model portfolios and advice and you have sure been a great guide.
I have 2 questions for you:
So far, the way I have been rebalancing has been by adding money to top up the ETFs so they are all in balance – as opposed to selling ETFs – Is this a strategy you would recommend or is there a pitfall to only adding money and not selling?

Secondly, in terms of asset allocation and tax efficiency while rebalancing, would it make sense for me to wait until I have room in my TFSA/RRSP to buy Bond ETFs and be temporarily out of balance – example: I have $10 000 to invest, $6 000 should go to VAB to rebalance, but instead I buy VCN and VXC because it is more tax efficient in my unregistered account than VAB (even though it temporarily puts my asset allocation out of whack)

Regarding the second question, you should never find yourself in a situation where you need to be way out of whack with your asset allocation. Certainly you should not be way out of balance simply because you want to avoid buying tax-inefficient ETFs in a non-registered account. If you want to email the details I can take a closer look and maybe write a blog post about this concept.